Following the December 2017 listing of futures contracts based on Bitcoin by two exchanges regulated by the Commodity Futures Trading Commission (CFTC), several fund sponsors and securities exchanges applied to the Securities and Exchange Commission (SEC) to list exchange-traded funds (ETFs) that would invest in those futures contracts. By investing in futures contracts regulated by the CFTC, instead of Bitcoin itself, these ETFs seemed designed to address concerns that had previously led the SEC to deny applications to list ETFs linked to Bitcoin. This change was not sufficient, however, as the SEC raised new concerns in early January that led to the withdrawal of these new applications. Exchanges, ETF sponsors and investors are now left wondering: what will it take for an ETF linked to Bitcoin to pass muster with the SEC?
Background on the ETF Listing Process
For a securities exchange to list ETF shares, either (1) the shares must meet minimum “generic listing standards” approved by the SEC or (2) the exchange must apply for an individual rule change with the SEC:
- Generic listing standards include requirements for trading volume, asset diversification, market value, and weighting of each ETF component. Currently, there are no generic listing standards that cover virtual currency.
- Applications for an individual rule change must be consistent with the standards set forth in the Securities Exchange Act of 1934 and SEC regulations, including (among other considerations) satisfying the requirement in Section 6(b)(5) of that Act that an exchange’s rules “prevent fraudulent and manipulative acts and practices.”
In light of this framework, exchanges seeking to list Bitcoin ETFs have done so by applying to the SEC for individual rule changes.
Initial SEC Rejection of Bitcoin ETFs
Bitcoin ETFs launched in the U.S. before December 2017 were designed to invest in the underlying Bitcoin spot market. Consistent with the CFTC’s determination that virtual currencies are commodities, the SEC analyzed these Bitcoin ETFs under the framework it has previously applied to commodity-trust ETFs. This analysis led the SEC to reject two applications and request the withdrawal of two others. In the denials, the SEC:
- Questioned whether rules permitting an ETF that invests in Bitcoin meets Section 6(b)(5)’s anti-fraud and anti-manipulation standard;
- Expressed concerns regarding the potential for manipulation of the ETF shares;
- Pointed to the need for “significant, regulated markets” in either the spot or derivatives markets for Bitcoin; and
- Stressed the importance that the applicant exchange is either a common member of the Intermarket Surveillance Group (ISG) with, or has obtained comprehensive surveillance sharing agreements (CSSAs) from, markets that cover 90% of trading in the ETF’s underlying asset, Bitcoin.
Of particular importance in the two denials is the SEC’s assertion that Bitcoin markets are not sufficiently regulated. The SEC noted that it could not conclude that Bitcoin markets are sufficiently regulated solely because certain BTC exchanges are regulated by the New York Department of Financial Services, some market participants are members of the Financial Industry Regulatory Authority (FINRA), and the CFTC could bring an anti-fraud enforcement action against conduct in the Bitcoin spot market.The Industry’s Response: Bitcoin Futures ETFs
The December 2017 listing of Bitcoin futures contracts on CFTC-regulated exchanges presented an opportunity for the industry to try to address the SEC’s concerns regarding earlier iterations of Bitcoin ETFs by structuring ETFs to invest in a regulated asset – Bitcoin futures contracts – instead of Bitcoin itself. Because the futures exchanges listing those contracts, the CBOE Futures Exchange and Chicago Mercantile Exchange, are both members of the ISG, the securities exchanges listing Bitcoin futures ETFs could satisfy the SEC’s requirement regarding intermarket surveillance. The listing securities exchanges also argued in their applications that other measures – including CFTC regulation of futures exchanges, FINRA regulation of broker-dealers participating in the ETF market, and the listing securities exchanges’ own trading rules and market transparency initiatives – would help protect investors in Bitcoin futures ETFs.
SEC Expresses Concerns Regarding Bitcoin Futures
These arguments did not persuade the SEC, however. Instead, the SEC staff requested the withdrawal of Bitcoin futures ETF applications, citing concerns regarding the liquidity and pricing mechanism of Bitcoin futures contracts. Although the SEC has not elaborated on these concerns, one might imagine them having concerns regarding the high volatility of Bitcoin futures contracts, which has frequently triggered trading halts. Concerns in this area might mirror concerns raised by other ETFs, such as certain bond ETFs, that invest in illiquid assets. In general, the SEC and many commentators have questioned whether it is appropriate to tie a liquid asset, such as ETF or mutual fund shares, to a less liquid asset.
The SEC might also question whether trading volume in Bitcoin futures is large enough relative to the overall Bitcoin market for securities exchanges to adequately monitor price movements and transaction activity through arrangements with futures exchanges. They could also have doubts regarding the approaches used by futures exchanges to calculate settlement prices, which rely on pricing from some of the same Bitcoin spot market exchanges that the SEC had questioned when rejecting earlier iterations of Bitcoin ETFs.
Implications and Next Steps
The SEC’s reaction to Bitcoin futures ETFs suggests that the Bitcoin futures market will need to mature and evolve before the SEC lets a Bitcoin-linked ETF proceed. In particular, increased trading volume in regulated futures markets and increased experience with futures contract settlement methods might help to address the SEC’s concerns. The SEC might also consider how it could partner with FINRA to address investor protection considerations through enhanced suitability and margin requirements. Ultimately, for as long as investor interest in Bitcoin remains high, it would seem beneficial to give investors more alternatives to trading in unregulated markets and through unregulated intermediaries.
 See, e.g., Self-Regulatory Organizations; NYSE Arca, Inc.; Notice of Filing of Proposed Rule Change to
List and Trade the Shares of the ProShares Bitcoin ETF and the ProShares Short Bitcoin ETF
under NYSE Arca Rule 8.200-E, Commentary .02, Exchange Act Release No. 82350 (Dec. 19, 2017); Self-Regulatory Organizations; Cboe BZX Exchange, Inc.; Self-Regulatory Organizations; Cboe BZX Exchange, Inc.; Notice of Filing of a Proposed Rule Change to List and Trade Shares of the REX Bitcoin Strategy ETF and the REX Short Bitcoin Strategy ETF, Each a Series of the Exchange Listed Funds Trust, Under Rule 14.11(i), Managed
Fund Shares, Exchange Act Release No. 82417 (Dec. 28, 2017); Self-Regulatory Organizations; Cboe BZX Exchange, Inc.; Notice of Filing of a Proposed Rule Change to List and Trade Shares of the First Trust Bitcoin Strategy ETF and the First Trust Inverse Bitcoin Strategy ETF, Each a Series of the First Trust Exchange-Traded Fund VII, under Rule 14.11(i), Managed Fund Shares, Exchange Act Release No. 82429 (Jan. 2, 2018).
 See Nikhilesh De, Bitcoin ETF Proposals Withdrawn After SEC Pushback, CoinDesk (Jan. 10, 2018) (Noting the withdrawals of all three ETF applications that the SEC gave public notice of, along with two others that had been submitted by Direxion Shares ETF Trust and VanEck Vectors ETF Trust. Neither the Direxion or VanEck proposals are addressed in this blog, which evaluates only those proposed rule changes that reached the notice and comment period.) available at https://www.coindesk.com/more-bitcoin-futures-etf-proposals-withdrawn-after-sec-pushback/.
 17 CFR § 240.19b-4.
 See Self-Regulatory Organizations; Bats Bzx Exch., Inc.; Order Disapproving A Proposed Rule Change, As Modified by Amendments No. 1 & 2, to Bzx Rule 14.11(e)(4), Commodity-Based Tr. Shares, to List & Trade Shares Issued by the Winklevoss Bitcoin Tr., Exchange Act Release No. 80206 (Mar. 10, 2017) and Self-Regulatory Organizations; Nyse Arca, Inc.; Order Disapproving A Proposed Rule Change, As Modified by Amendment No. 1, Relating to the Listing & Trading of Shares of the Solidx Bitcoin Tr. Under Nyse Arca Equities Rule 8.201, Exchange Act Release No. 80319 (Mar. 28, 2017).
 See e.g. Self-Regulatory Organizations; Nyse Arca, Inc.; Order Granting Approval of A Proposed Rule Change to List & Trade Shares of the Proshares Managed Futures Strategy Fund, Proshares Commodity Managed Futures Strategy Fund, & Proshares Fin. Managed Futures Strategy Fund Under Nyse Arca Equities Rule 8.200, Exchange Act Release No. 66334 (Feb. 6, 2012) (stating approval where “not more than 10% of the weight of a Fund’s portfolio in the aggregate shall consist of components whose principal trading market is not a member of ISG or is a market with which the exchange does not have a comprehensive surveillance sharing agreement”).
 See Winklevoss Bitcoin Trust supra n.4 at *14.
 Id. at *15; see also SEC analysis in SolidX Bitcoin Trust at n.4.
 First Trust’s Request for Withdrawal (Jan. 9, 2018), available at https://www.sec.gov/Archives/edgar/data/1561785/000144554618000121/etf7_aw.txt.
 Cf. Winklevoss Bitcoin Trust supra n.4 at *36.